One of the variables that you should always look out for as you manage your investments is the interest rate. It isn’t the only factor you need to consider, but it is an important one. We will begin by explaining what interest rates are, and then explore their impact on investments.
What Is an Interest Rate?
In the simplest terms, an interest rate is the cost of borrowing money, or the return of investment for lending money – depending on which side of the transaction you stand. The interest rate differs depending on the specifics of a particular transaction and the parties involved in it. When we talk about the interest rate, we are usually referring to the rate that the Bank of Canada (BoC) charges other banks on overnight loans, also known as the repo rate. This is the primary interest rate in the economy, and private lending institutions will generally base their interest rates on its movements. When the BoC raises or lowers its lending rate, other banks follow suit, and the entire economy will feel the effects.
What Happens When Interest Rates Rise?
When the BoC increases the discount rate, short-term borrowing costs increase across all financial institutions. All individuals and companies then have to pay more to borrow money than they did the day before. Levels of disposable income among households drop as people have to make higher payments on credit cards, mortgages and other debts. Consumer demand will then decrease, meaning that company revenues will also drop.
How would this affect your investment portfolio? Increases in the interest rate will affect different investments in different ways. Equities generally have an inverse relationship to the interest rate, so when the interest increases, the value of equities will tend to decrease. The higher cost of borrowing and the resulting drop in consumer demand lead to lower revenues for businesses, which means that shares will lose some of their value. The same is true of real assets and commodities, although the exact relationship is a little more complex. Even debt instruments like bonds have an inverse relationship to the interest rate.
What Happens When Interest Rates Fall?
The exact opposite is true when interest rates fall. When the BoC reduces the discount rate, it is usually intending to stimulate the economy. A lower interest rate means that it costs less to borrow money, which in turn, means that consumers and businesses pay less on their debts, freeing up more disposable income, increasing investment, and leading to a rise in consumer demand. That increase in demand will cause the values of stocks, equities, real assets, and bonds to rise as well.
Short-Term vs. Long-Term Interest Rates: Impact on Investments
Interest rates can fluctuate in the short term or remain fairly constant for an extended period. Their movements can be difficult to predict in the long term, but investors and their advisors can always make adjustments as they change in the short term. When it comes to your investments, it is long-term bonds that are most likely to feel the impact of changing interest rates. When interest rates rise, bond prices fall (and vice versa). Long-term bonds are most sensitive to these changes because they have a greater duration and more upcoming coupon payments. Your financial advisor can help you navigate these shifts by adjusting the makeup of your portfolio to minimize the impact of changing interest rates, usually by shifting the mix between long-term and short-term bonds.
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